BlackRock Investment InstituteSeptember 2012

Got Liquidity?

[ 2 ] G O T L i q u i d i T y ?

Richard Prager Head of BlackRock Trading

and Liquidity Strategies

Ewen Cameron Watt Chief Investment Strategist,

BlackRock Investment Institute

BlackRock investment institute

The BlackRock investment institute leverages the firm’s

expertise across asset classes, client groups and regions.

The Institute’s goal is to produce information that makes

BlackRock’s portfolio managers better investors and helps

deliver positive investment results for clients.

Lee Kempler Executive Director

Ewen Cameron Watt Chief Investment Strategist

Jack Reerink Executive Editor

What is insideFirst Words and Summary 3

Collateral damage 4

The Liquidity Challenge 5

Phantom Liquidity 7Supurna Vedbrat Co-head of BlackRock Market Structure

and Electronic Trading team

drivers of the Liquidity Challenge

New financial services regulations are facts of post-crisis

life. They are meant to reduce the risk of a new credit crisis

and to boost transparency to politically acceptable levels.

Banks and dealers have already started to comply by

pulling back from trading and selling “risky” assets.

Higher Capital Standards: Basel III requires banks to

increase equity to 7% of their risk-bearing assets by 2019,

almost three times the current requirement. Global banks

must hold an additional 2.5%. Banks can beef up capital

by raising new equity (costly because of little investor

appetite) or reducing risk assets (bad for market liquidity).

Banks must hold enough “high-quality liquid assets” to

match expected cash outflows in a 30-day period.

Proprietary Trading Curbs: The Volcker Rule, part of the

Dodd-Frank Wall Street reforms, limits proprietary trading.

Regulators elsewhere are implementing similar measures.

Chris Vogel Head of BlackRock Fixed Income

Trading, Americas

The opinions expressed are as of September 2012, and may change as subsequent conditions vary.

Bans and Taxes: Short-selling bans hurt liquidity in the

underlying instruments, especially because they typically

come at a time of market distress—when liquidity is

already challenged. Financial transaction taxes can

damage liquidity and ultimately raise costs for investors.

Back to Basics: Some complex and poorly understood

structured products blew up during the financial crisis.

Many investors are now avoiding them, harming liquidity

in credit markets. Meanwhile, regulators are changing the

landscape by requiring central clearing of many over-the-

counter (OTC) derivatives.

Ratings Downgrades: Ratings agencies are downgrading

sovereign debt and banks. The first forces banks to further

beef up capital to account for sovereign debt holdings that

are now seen as too risky. The second hurts their ability to

function as counterparties to OTC and other transactions.

B L A C k R O C k i n v e S T M e n T i n S T i T u T e [ 3 ]

First Words and Summary

Powerful forces are reshaping trading in financial markets:

raised capital requirements, curbs on proprietary trading, moves

toward central clearing of swaps and the steady drumbeat of

ratings downgrades of sovereign debt and global banks. These

changing regulatory and political tides, partly triggered by the

financial industry’s self-inflicted wounds of trading losses and

excesses, increase the risks of reduced market liquidity.

The likely end result? A more transparent but less vibrant

marketplace for many securities and higher costs for investors.

This means higher bid-ask spreads on individual securities,

price gaps in response to macroeconomic news headlines,

and—most importantly—less room to carry out sizable trades

without significantly affecting the security’s price.

Fixed income markets are showing the contours of this new

liquidity world. Ostensibly, these markets are booming. New

issuance is setting highs as companies take advantage of

record low interest rates. Yield-hungry investors are bidding

up prices of corporate bonds and other spread products.

Things are a bit clunkier beneath the surface. Traders are

splitting orders into small chunks to get them done. Liquidity is

concentrated in large and new issues, and drops precipitously

for smaller and older bonds. Liquid bonds are increasingly

trading at a premium to others. And nobody really wants to

contemplate what liquidity will look like once the bull market

in credit runs out of steam or reverses.

For now, there is still ample liquidity and a drying out in the near

future appears highly unlikely. But things are changing rapidly.

Investors do well to adjust to the new world of trading and keep

in mind we have only seen its very beginnings:

} Forget a return to the credit-fueled hey days of the early

2000s. Markets were awash in liquidity and leverage then,

with great market depth (the ability to carry out large trades

quickly with minimal market impact) and the tightest bid-ask

spreads on record. This was likely an anomaly.

} A “back to the future” scenario is likely. This means markets

with pockets of liquidity, price differentials based on how

easy it is to buy or sell a security, and a renewed appreciation

for skills to carry out financial transactions across a plethora

of trading venues. This exposes portfolios to risks but also

offers opportunities to smart investors.

} Watch market impact. Poor liquidity sometimes will mean

investors can allocate fewer funds to their best investment

ideas than they would like. A disciplined investor typically

evaluates if market depth is great enough to initiate a trade—

and, more importantly, can facilitate an exit. Compare it to

a lobster pot: Easy to get into, but tough to crawl out of.

} Perfect hedges are a mirage. The financial crisis showed that

liquidity is king and diversification often doesn’t work in times

of market stress. As a result, many hedges are going to take

the shape of blunt (liquid) instruments traded on exchanges,

rather than customized products that look great on paper. For

example, call options on long-dated US Treasuries currently

are a hedge against broad risk-off market moves.

} Liquidity can be used in relative value investing. This is a key

strategy in stagnant markets with bouts of risk-on/risk-off

trading as detailed in “Standing Still… But Still Standing” in

July 2012. Investors can take advantage of situations where a

security’s liquidity premium or discount runs counter to their

assessment of the underlying value. Those with long time

horizons can exploit illiquidity by picking up hard-to-trade,

discounted assets.

} Better price transparency does not necessarily mean better

liquidity. In fact, the opposite may happen. Dealers do not

like to advertise their holdings for fear of getting stuck with

them—especially at a time when it is becoming costlier to

hold risk assets on their balance sheets.

So What do i do With My Money?TM

Pre-Trade Homework: Evaluate an investment’s likely

market impact. At what price can you enter and exit the

trade? Some of your best investment ideas may have to

take a back seat.

Blunt Tools: Use liquid, exchange-traded hedges to protect

your portfolio. They may be imperfect—but at least they

are tradable.

Liquidity Opportunities: Investors with longer time

horizons can try to take advantage of price differences

between liquid and tough-to-trade securities.

[ 4 ] G O T L i q u i d i T y ?

Repo Regression european Repo Market Trends, 2001–2012

MA

RK

ET S

IZE

(€ T

RIL

LIO

NS)

Market Size ■Euro Share

EUR

O R

EPO SH

AR

E (%)

0

1

2

3

4

5

6

7

40

45

50

55

60

65

70

75

2001 2007 20112003 2005 2009

Source: International Capital Market Association’s European repo market survey. Note: Data based on bi-annual surveys. Data through the second quarter of 2012.

Collateral Damage

The world looks awash in liquidity. Central banks have pushed

interest rates to record lows and have gone on asset buying

sprees to resuscitate economic growth. Purchases of

government paper and other securities by the central banks

of the US, eurozone, China, Japan, Britain and Switzerland

have added almost $9 trillion in monetary stimulus since 2007,

according to Deutsche Bank research.

This geyser of monetary liquidity has not resulted in as much

credit creation as one might expect. In fact, money multipliers in

the developed world have steadily declined over the past decade,

keeping a lid on inflation in most developed countries. Why?

Credit ultimately is dependent on collateral—and investors have

become much pickier about collateral since the financial crisis.

They are highly selective and are hoarding safe-haven assets

such as US, Japanese, German and UK government bonds.

New regulations such as centralized clearing of OTC derivatives

are driving up demand for high-quality assets even more—and

encourage more hoarding of this elite (and by many measures

overpriced) group of government bonds.

The near-death of structured products (market-linked

investments that use OTC derivatives) shows the mirror image of

this trend: avoidance of assets seen as too risky. The business of

packaging and selling structured products underpinned much of

the trading in fixed income instruments during the Great Bubble

of the early 2000s. (It also generated huge investment banking

and trading profits—which were wiped out when the market

imploded.) This once thriving market is now a drag on liquidity.

Demand for structured products has dried up as investors prefer

“back-to-basics” strategies, and are suspicious of financial

engineering and fearful of risk. Financial intermediaries are

unable or unwilling to create and support new structured

products due to tighter capital rules and a general de-risking.

As a result, issuance of collateralized debt obligations (CDOs)

has imploded. See the chart below, left. This in turn has

dampened activity in other credit markets—even though

supply, demand and outstanding value of corporate bonds

and emerging market debt are at record highs.

Another example is the repo market, where banks access

funding from money market and pension funds in repurchase

agreements. This market shows the effects of risk aversion—and

illustrates how monetary policy is changing trading and liquidity.

The repo market has made a comeback from the crisis days,

when worries about counterparty risks and the safety of

underlying collateral slashed volumes. But new stresses are

showing up. The size of the European repo market, for example,

contracted 10% to a two-year low of €5.6 trillion in the first half.

At the same time, the number of euro-denominated transactions

hovered around a record low of 57%. See the chart above.

The declines show both decreasing risk appetite (mistrust of

counterparties) and the competing effect of monetary policy.

Two long-term refinancing operations (LTROs) by the European

Central Bank have given European banks access to easy and

cheap cash, reducing their need to tap the repo market.

CDO

ISSU

AN

CE ($

BIL

LIO

NS)

Issuance Outstanding

OU

TSTAN

DIN

G CD

OS ($ B

ILLION

S) 0

100

100

300

400

500

0

300

600

900

1,200

1,500

20022000 2004 2006 2008 20122010

A Great Credit Machine Grinds to a HaltOutstanding CdOs and issuance, 2000–2012

Source: US Securities Industry and Financial Markets Association. Note: Data through the second quarter of 2012.

B L A C k R O C k i n v e S T M e n T i n S T i T u T e [ 5 ]

The Liquidity Challenge

Investors usually hail inventory declines as good news. Falling

inventories point to a future increase in activity: Either demand

is strong or businesses need to restock—or both.

Not so in the world of trading. A decline in inventory typically

equals a decline in liquidity. If you have fewer items on your

shelf, chances are you sell less (unless you offer deep discounts).

This is what has happened in the corporate bond market. Risk

aversion and preparation for stricter capital rules have caused

dealers to empty their inventories. Inventories of US corporate

bonds now total $59 billion, down 79% from a high of $286

billion in late 2007. See the chart on the right.

Over the same period, the US investment grade bond market

grew by about half to more than $3 trillion, as issuers took

advantage of low rates and investors hunted for yield. The US

high yield market also grew, and now stands at well over $1

trillion. The mismatch between low trading inventories and high

demand and issuance is one factor that is restraining liquidity.

Dealers have swapped their corporate bond holdings for (mostly

short-dated) US Treasuries, courtesy of the US Federal Reserve’s

selling bills to buy long-dated Treasuries in “Operation Twist.”

BES

T-TO

-CO

VER

LEV

EL

($ C

ENTS

)

US High Yield Emerging Market DebtEuropean High Yield

0

50

100

150

200

250

2012201120102009200820072006

Rising Trading Cost Tide Best-to-Cover Levels of Fixed income Markets, 2006–2012

Source: MarketAxess. Notes: The best-to-cover level is the difference between the executed trade price and the second-best dealer bid/offer. Data in US cents of bond price levels. European high yield data from April, 7, 2008; other data from Jan. 3, 2006. All data through Aug. 13, 2012.

The Great De-RiskinguS dealer inventories, 2001–2012

DEA

LER

PO

SITI

ON

S ($

BIL

LIO

NS)

20032001 2005 2007 2009 2011

-200

-100

0

100

200

300

Corporate BondsGovernment-Sponsored Enterprise DebtTreasuries

Mortgage-Backed Securities

Sources: MarketAxess and Federal Reserve Bank of New York. Note: Data through July 11, 2012.

Dealer positions in US mortgage-backed securities (MBS)

have gradually increased and now outnumber corporate bond

inventories, resulting in a vibrant agency MBS marketplace.

This market is supported by three sets of bidders: the Fed,

banks adding “quality assets” to adhere to the new Basel III

capital rules and real estate investment trusts, as detailed in

“in the Home Stretch? The uS Housing Market Recovery” in

June 2012.

By contrast, falling dealer inventories of corporate bonds

are starting to challenge liquidity in those markets. Liquidity

constraints may not yet be visible or felt—but they are more

likely to get worse than better.

Things look good on the surface. Best-to-cover levels—which

measure the gap between the trade price and the next-best

offer—are way down from crisis levels. They rose during the

European debt crisis in late 2011, but are now only slightly

elevated from pre-crisis levels. See the chart on the left.

[ 6 ] G O T L i q u i d i T y ?

BID

-ASK

SPR

EAD

(BA

SIS

POIN

TS)

0

10

20

30

40

50

20032001 2005 2007 2009 2011

A New Bid-Ask Normal?Bid-Ask Spreads on uS investment Grade Bonds, 2001–2012

Source: MarketAxess. Notes: Bid-ask spreads are daily estimates in basis points. The dark blue line represents a smoothed-out average. Data through July 25, 2012.

Bid-ask spreads on US investment grade bonds show a slightly

constrained liquidity picture. Spreads are far off their 2008–

2009 highs, but elevated from last year and pre-crisis levels.

See the chart above. US high yield bid-ask spreads have

followed a similar path and now average $0.31, albeit with much

wider dispersion, according to trading platform MarketAxess.

More importantly, markets have become shallower. This has

led to increased liquidity concentration in new issues, and

liquidity dropping off for older issues or run-off securities.

PER

CEN

TAG

E O

F VO

LUM

E

0

10

20

30

40

50%

Odd LotsRound Lots Block Trades Micro Trades

201220112010

Work That Order! Trade Sizes of uS investment Grade Bonds, 2010–2012

Sources: MarketAxess and TRACE. Notes: Micro < $100,000; Odd = $100,000–$1 million; Round = $1–5 million; Block > $5 million. Data through June 2012.

MA

RK

ET V

ALU

E ($

TR

ILLI

ON

S)

TRACE Investment Grade Trading Volume ■Market Value Trading Volume as % of Market Value

2012E2010200820060

30

60

90

120

150%

1

1.5

2

2.5

3

3.5 PERCEN

TAGE O

F MA

RK

ET VALU

E

Sources: BlackRock, Barclays and TRACE. Notes: 2012 estimates are annualized first-half data. 2012 market value as of June 29, 2012.

For example, the top 2% of investment grade bonds by volume

rose to almost a third of overall trading in the first quarter,

according to MarketAxess. And the top quintile of bonds by

volume accounted for 93% of total turnover.

The liquidity is bunched up in large new issues. Only issues of

more than $1 billion and those less than a year old recorded

volume growth in 2011, according to MarketAxess. Liquidity of

older and smaller bonds dropped across the board.

The result? Many traders are now splitting up large orders in

US investment grade bonds to find buyers and sellers. The

average trade size was $381,000 in June, down 17% from a

year earlier. Trades of more than $5 million now make up 36%

of the overall volume, down from 45% a year ago. See the left

chart below.

Poor liquidity is depressing overall trading—even as yield-hungry

investors bid up prices and companies take advantage of historic

low financing rates by issuing more debt. Trading volumes hit a

high of nearly $3 trillion in 2009 and then leveled off. This year

volumes are on track to slightly exceed their 2009 highs—but

remain subdued as a percentage of the total value of outstanding

debt. See the right chart below.

As a result, highly liquid bonds now carry a premium of around

16 basis points over less liquid ones, according to J.P. Morgan

research. This compares with an average premium of about

6 basis points in the past seven years. See the chart on the

following page. By contrast, the MBS liquidity premium has

remained stable at 6 basis points (as measured by the spread

between Fannie Mae and Freddie Mac securities).

When Liquidity Dries UpTrading volumes of uS investment Grade Bonds, 2005–2012

B L A C k R O C k i n v e S T M e n T i n S T i T u T e [ 7 ]

The Liquidity PremiumPremium of Liquid uS investment Grade Bonds, 2005–2012

LIQ

UID

ITY

PREM

IUM

(BA

SIS

POIN

TS)

-10

0

10

20

30

40

20122011201020092008200720062005

Liquid Bonds Rich

Liquid Bonds Cheap

Average Liquidity Premium = 6 bps

Sources: J.P. Morgan and TRACE. Notes: The liquidity premium is the spread between US investment grade bonds of the same issuer with similar maturity and daily volume of $3 million or more (liquid) and $1 million or less (less liquid). Spreads are monthly moving averages. Data through July 26, 2012.

Phantom Liquidity

Things look hunky-dory in equities, with bid-ask spreads

ever narrowing. The average spread on S&P 500 stocks now

is slightly more than a penny, according to Morgan Stanley.

Thank decimalization, automation, the advent of high frequency

trading and a host of new trading venues.

In reality, these narrow spreads amount to nothing more than

phantom liquidity. Sure, the spread is a penny for 100 shares.

But what happens when you want to transact a million shares?

For most stocks, there’s no market. Consider:

} Block trades (trades of 10,000 shares or more) in S&P 500

companies make up less than 7% of total volume, down from

nearly 50% in the early 1990s. See left chart below.

} The average trade size of NYSE-listed stocks is down 75%

from the early 2000s. See right chart below.

Transparency at a Price

Many new rules call for more price transparency, including

for OTC derivatives and US municipal bonds. The hope is to

create a level playing field and boost liquidity by attracting

new market participants.

The opposite effect, however, is a real possibility: Some

existing participants may withdraw for fear of tipping their

hand if their trading books are broadcast.

This is not to say price transparency is bad—far from

it. It is merely to flag unintended consequences. These

outcomes may be temporary as markets adjust, they

may be permanent or they may not happen at all.

Whichever the case, it pays to be prepared.

Phantom LiquidityBlock Trades, Turnover and Trade Sizes of uS Stocks

Sources: Morgan Stanley and New York Stock Exchange. Notes: S&P 500 block trades are calculated by dividing each constituent’s dollar volume by the dollar volume of trades that exceed 10,000 shares. Daily data through July 26, 2012. Turnover is each SPX constituents’ daily volume as a percentage of its outstanding shares. Data through July 2012. Data for trade sizes of NYSE-listed stocks is through June 2012. All data are consolidated trading.

PER

CEN

TAG

E O

F D

AIL

Y VO

LUM

E

S&P 500 Block Trades

0

10

20

30

40

50%

200920072005200320011999199719951993 2011

0

250

500

750

1,000

0

0.5

1

1.5

2%

201220112010200920082007200620052004

NU

MB

ER O

F SH

AR

ES

Average S&P 500 Turnover Average NYSE-Listed Stock Trade Sizes

AVERAG

E TUR

NO

VER

Not FDIC Insured • May Lose Value • No Bank Guarantee

This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2012 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents.

This paper may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.

Issued in Australia and New Zealand by BlackRock Investment Management (Australia) Limited ABN 13 006165975. This document contains general information only and is not intended to represent general or specific investment or professional advice. The information does not take into account any individual’s financial circumstances or goals. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial or other professional adviser before making an investment decision. In New Zealand, this information is provided for registered financial service providers only. To the extent the provision of this information represents the provision of a financial adviser service, it is provided for wholesale clients only. In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). In Hong Kong, this document is issued by BlackRock (Hong Kong) Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong. In Canada, this material is intended for permitted clients only.

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The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

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Lit. No. BII-LIQUIDITY-0812 AC6263-0812

High frequency traders would argue they play a crucial role in

providing liquidity. Critics contend they provide real liquidity

only in stocks that are already liquid.

Foreign exchange shows few signs of liquidity constraints, as it

is a flow business that does not carry a capital charge. Bid-ask

spreads on spot foreign exchange markets spiked during the

financial crisis but have since come down—although they remain

above pre-crisis levels in less-traded pairs such as the New

Zealand dollar and Norwegian krone. See the chart below.

BID

-ASK

SPR

EAD

(BA

SIS

POIN

TS)

Australian Dollar-USD Euro-Norwegian Krone

Euro-USDNew Zealand Dollar-USD

0102030405060708090

201220112010200920082007

Awash in LiquidityBid-Ask Spreads in Spot FX Markets

Source: BlackRock. Notes: Based on quarterly BlackRock survey of 15 to 19 foreign exchange dealers. Bid-ask spreads in basis points are based on the average spread on a $100 million transaction dealers commit to 90% of the time. Data through June 2012.

How We Tackle the Liquidity Challenge

BlackRock is pioneering new ways of doing business to

ensure clients have access to a full range of investments:

Capital Markets: A new desk that works with investment

banks to source fixed income directly from issuers. This

“originate to manage” model is meant to meet client needs

for new corporate bond issues, allow customization and

deliver intelligence about market trends.

Crossing and Matching: New trading platforms for equities

and fixed income. Internal crossing networks enable buying

and selling of securities between BlackRock portfolios and

client accounts. A trading network for institutional clients

allows access to a broad set of market participants.

eTrading: New systems to tap into the liquidity of electronic

trading venues. Already far advanced in equities, electronic

trading is just starting to transform fixed income and foreign

exchange markets.

Adding Brokers: An emerging brokers program targets

enterprises owned by women and minorities as well as

firms with regulatory capital of less than $2 million.

OTC Central Clearing: A central clearing entity such as

the Chicago Mercantile Exchange could become the

counterparty in selected OTC transactions and reduce risk.